“If you’re paying taxes, it means you’re making money.” That’s a yearly quote from my ever-optimistic father. I acknowledge it sure doesn’t feel good to see how much of your money goes to taxes, but my dad is right (don’t tell him I said that).
Given it’s almost tax time – be sure you file or defer by Tax Day – I thought a primer on how federal taxes are calculated would be helpful. Because each state has different income tax rates (and some states have no income tax at all!), I’m going to stick with federal rates, since they apply to all US citizens. I’m also not getting political here, so everyone can collectively grit their teeth about how much money they have to pay without getting further enraged by political commentary.
For the purposes of this blog post, all taxes will refer to United States Federal Income Taxes.
The Federal Government charges a progressive tax rate on taxable income (that just means it adjusts as income increases – more on this below). Taxable income is the total income you make, otherwise known as gross income, less either the standard deduction or itemized deductions.
For 2018, this amount is $12,000 for single filing and $24,000 for married filing jointly. Even if you have no deductions to take on your gross income, everyone is entitled to take the standard deduction, no questions asked. This amount is subtracted from your gross income to get to your taxable income number.
In some cases, itemized deductions will total more than the standard deduction. Such deductions may include expenses related to a business, medical costs, mortgage expense, or charitable donations. If your itemized deduction totals more than the standard deduction, you should elect to itemize your deductions (just make sure you have receipts to provide evidence!). As with the standard deduction, your taxable income number is your gross income less the total of your itemized deductions.
The Economic Principle:
Progressive tax rates break income into increasing brackets and tax each bracket of money at a specific rate. As the brackets increase, the actual rate at which the higher brackets are taxed increases as well. Most people get confused here because they think that means that one incremental dollar increase in salary could push them to a higher tax rate on their entire taxable income. That is not quite true. If, for example, the first bracket cuts off at $10,000 and the next bracket cuts off at $20,000 and you make $15,000, your first $10,000 will be taxed at the rate for that bracket and the next $5,000 will be taxed at a slightly higher rate because it is in the next bracket. You wouldn’t be taxed at the higher rate for the entire $15,000. I can hear you screaming “VISUAL PLEASE” from behind your screen.
2018 Tax Schedule and Rates:
Effective Tax Rates:
Essentially, if your income spreads you across multiple brackets, you can calculate the overall tax rate, also known as your effective rate, by taking the total you pay for each bracket and dividing it by your total taxable income. In the example below, you can see how varying taxable incomes translate for a married couple and what their effective rates are.
As taxable income increases, your income gets broken out in to higher and higher brackets. In the example above, someone making $200,000 pays the same amount in taxes on the first $19,050 and $77,400 as someone earning $100,000. The person with $200,000 in taxable income is paying a total of $36,579 in taxes which equates to an effective tax rate of 18.3% ($36,579/$200,000), even though the highest tax bracket they hit is 24%.
There’s More to It:
This blog post is simply a primer on tax rates. While there are many other considerations, including terms I’m sure sound familiar, such as capital gains taxes, AMT, and SALT deductions, I wanted to keep it simple. Hopefully you get your taxes done early and then you don’t have to think about them again until next year. If you want some peace of mind, or this article suddenly reminded you that you have just a couple of weeks left until the filing date, it may be worthwhile to spend a bit of money to get TurboTax, which will walk you through the process and make it easier on you to get your taxes done. Until then, good luck!
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